Facebook – Unrealistic Expectations

Facebook (NASDAQ:FB) is one of the prominent “FANG” stocks. The stock was one of the best performers in 2015 being up about 25%. Facebook is a social networking company. The company is engaged in developing products that enables users to connect and share through mobile devices and personal computers. Today about 80% of users use the social network on a mobile device. Facebook offers various platforms for people to share their opinions, ideas, photos and videos, and to engage in other activities. The Facebook umbrella encompasses Facebook, Instagram, Messenger and WhatsApp. Messenger is a mobile-to-mobile messaging application available on iOS and Android phones. Instagram is a mobile application and Website that enables people to take photos or videos, and share them with friends and followers. WhatsApp Messenger is a cross-platform mobile messaging application and allows people to exchange messages on iOS, Android, BlackBerry, Windows Phone and Nokia devices.

Total Addressable Market

The company announced last quarter that it now has 1.6 billion monthly active users (MAU’s) on its flagship platform. This is a staggering 23% of the entire planet’s population. The world population today comprises approximately 7.2 billion people. Of this total, six billion people fall with within the ages of 10-89 years old. These six billion could be considered to be potential users of FB.

Now, lets take a look at the amount of people within the six billion who live in poverty or extreme poverty. Even if this group is ever given access to a computer that is connected to the internet, they are unfortunately unlikely to add value to FB since advertisers will not pay to display ads. It is estimated that three billion people live on less than $2.50 per day and an additional 1.6 billion people do not have electricity. These are incredible statistics. As far as Facebook goes, we can interpret that Facebook has a total addressable market of about two billion people. As of today, they would therefore have 80% of their total addressable market. I think that it is reasonable to assume that growth in users will be challenging going forward. Here is what Facebooks MAU growth looks like today:

Revenue Growth

Analyst expectations for revenue growth remain incredibly euphoric. Analysts expect FB to generate revenue growth of 42.2% in 2016 and average 34% growth per year for the next five years. I think this is wildly optimistic and I don’t see where the growth is expected to come from. The U.S. and Canada is where the company generates the most revenue per user. I think it is reasonable to say that there is an equal probability that in five years, Facebook may have less users in the U.S. and Canada than today. Facebook doesn’t fix any type of problem or issue. If anything, it creates problems and reduces productivity. I think most people who want to be on Facebook in the U.S. and Canada have already created an account at this point. Please see the chart below showing average revenue per user (ARPU):

It is clear the U.S. and Canada is the most important part of the world for Facebook. The U.S. and Canada generates almost three times as much revenue as the next best region. However, most of their user growth today is coming from Asia-Pacific and Rest of World. The problem is, these regions are the two worst ARPU producers. I wouldn’t expect this to change dramatically going forward because this metric is driven by advertisers and how much they are willing to pay to advertise. Advertisers are aware that the U.S. and Canada is the best place to advertise and they are not going to pay to advertise to the Rest of World region if they can’t sell products. Once investors realize the U.S. and Canada is a very mature market and will be challenged going forward, the valuation of the company might be dramatically reduced.

Facebook’s Video Problem

Facebook announced last quarter that over 100 million hours of video per day is watched on its site. Over 500 million users watch video on FB each day and over 8 billion videos are viewed per day. Mark Zuckerberg said last quarter that video will be very important going forward. But where are these videos coming from? Most of the videos are being stolen from YouTube and other content creators then uploaded to Facebook. Last year, 68% of Facebook’s top video content were stolen videos from other sites that did not give permission to have their video on Facebook. This equates into 92% of all the video views. Stolen videos are actually preferred in Facebook’s algorithms because they receive more views and they keep people on their site for longer. When content creators are made aware that their video has been stolen and posted to Facebook, they are forced to go through a difficult process to report the stolen video. Only after this will FB investigate. Often times, it can take several days for them to respond to the content creator. In these few days, the video will have gone viral and received most of the views that it will ever receive while on FB. Sometimes Facebook will respond by taking the stolen video down but often times they will do nothing. They will instruct the content creator to ask the person who stole the video to take it down. An example of that is shown below:

It is not surprising that Facebook is so relaxed about this since they are making billions in revenue off of these stolen videos. This screenshot above was what YouTuber Ethan Klein received from Facebook several days after one of this videos was stolen.

I believe that this practice is unsustainable for Facebook. I think there is a high probability that litigation is coming soon. Either from the content creators or from Alphabet (who owns YouTube). Facebook will have to make a content ID system that prevents copyright infringement. This could hurt them badly. Not only will their metrics take a big hit but also the user experience will be drastically affected which could cause people to leave the platform all together.

Valuation

The company’s valuation has always been astronomical. However, they have done an extraordinary job running the company and outperforming even the most optimistic estimates. It seems like these type of stories never end well. Eventually growth will slow and the company will miss estimates. At that point, the valuation will come down to earth.

It seems like investors have decided to ignore the expensive valuation and analysts are in love with the stock. Out of the forty nine analysts covering the stock, forty four have it rated as a buy and only one as a sell. The expectations are high and if the company can’t perform, the stock might take a hit. It seems like the stock is priced for perfection and the catalyst of the stock getting an analyst upgrade is pretty much off the table.

In the above valuation, the inputs used are much lower than those used by analysts. Current estimates expect the company to growth earnings at 32.3% per year for the next five years. My normal growth estimate for the same time period is 15% per year. I think this is a more realistic figure. Based on the trailing twelve months earnings of $1.30, the company trades at a whopping 81x earnings. Using the Graham valuation formula, I reached a per share value of $68.25 which is in line with the median value of my valuations. The median value suggests that the stock might be overvalued by approximately 34%.

Conclusion

Facebook’s management has executed near perfectly ever since the stock became public. However, it seems like the interest of its users is video and FB does not have high quality video content. I think it is only a matter of time before there will be litigation regarding theft of content being posted to FB by users. Without these stolen videos, the Facebook user experience may deteriorate. This problem coupled with the total addressable market and average revenue per user issues makes the stock potentially toxic.